Be Prepared for Those One in a Million Events

The biggest news right now is fear of a massive radiation leak in various parts of Japan in the wake of the devastating earthquake and tsunami last week.

Aside from the horrific human tragedy that has occurred in Japan, there are a lot of economic and political issues that are the main focus of the media.

The political issues revolve around the issue of how safe nuclear power is. The economic issues have mostly focused on the effect this tragedy economic growth in Japan and abroad.

However, there is another topic, which happens to be a very important lesson, not getting too much coverage.

The issue I want to focus on has to do with something called “Black Swan” events. The “Black Swan Theory” was popularized by Nassim Taleb, a famous best-selling author and philosopher. In fact, Taleb stated yesterday that he got 600 interview requests after the earthquake in Japan.

A Black Swan event is a highly unpredictable major event that in hindsight seemed obvious. A perfect example is the recent uprisings in the Middle East. No one predicted on Dec. 31, 2010, that Hosni Mubarak would no longer be president of Egypt in two months. Yet, in hindsight pundits state now that it was a completely rational event, which was bound to have occurred.

The earthquake in Japan is another example of a Black Swan event.

Taleb notes that the Japanese Nuclear Commission in 2003 set the goal of safety measures, which would result in a one in a million chance of fatal radiation leaks in the vicinity of nuclear power plants. Only eight years later, the event that was supposed to happen once in a million years has occurred.

Taleb states that “model error causes the underestimation of small probabilities and their contribution.” This means that tacticians, economists and analysts tend to ignore a small outcome thinking that it is very unlikely.

Taleb notes in his book that Black Swan events are increasing in frequency due to globalization.

There have been Middle East uprisings, toppling regimes that have existed for decades; a large earthquake in New Zealand; floods in Australia, and the Japan disaster — all within the first three months of 2011.

So where does that leave the investor?

There is a specific lesson regarding insurance companies that comes to mind. Insurance companies in general do a great job helping people buy insurance by calculating possible risks of an event happening, charging enough money to cover claims, while turning a profit for the owners.

For example, a life insurance company does a fair job at assessing someone’s risk of dying and pooling all the money together in case things do not go as planned. If the insurance company has 10 million members, and one perfectly healthy 20 year old unfortunately gets hit by a car, the life insurance company can pay the tab.

But do life insurance companies asses the possibility of one million people being killed by an asteroid, nuclear attack, or some other unforeseen event? It seems they do not. I strongly doubt that insurance companies on August 22nd 2005 (the day before Katrina formed as Tropical Depression) accounted for a flood that would destroy New Orleans, and cost insurers over $70 billion.

To bring this topic to general investing, do investors account for risks?

There will be a major Black Swan event in the future. It could happen tomorrow, in a month, and in all likelihood sometime within the next few years.

It is impossible to predict what the event will be (except in hindsight), but the way investors could prepare is by always keeping a large amount of cash in their portfolio.

The biggest news right now is fear of a massive radiation leak in various parts of Japan in the wake of the devastating earthquake and tsunami last week.
Aside from the horrific human tragedy that has occurred in Japan, there are a lot of economic and political issues that...